Are Buybacks a Warning Sign?

At the end of the second quarter of this year, S&P 500 companies (not
including financial stocks), had over $1.2 trillion in cash and short-term
investments on their balance sheet. This cash position is at its historically
high levels, observes Joon Choi in Systems &
Forecasts.

So, what are corporations doing with this excess cash position? They are
buying back their own stocks! And aggressive stock buybacks are pushing stock
prices higher.

I have listed primary reasons for the current trend of buying back
stocks:

1. The companies see their stocks as undervalued that would make good
investments.

2. Buying back stocks enables companies to raise the earnings per share
without actually increasing earnings.

3. Many company executives have stock option incentives tied to their
performance, so they initiate or increase stock buybacks, which creates extra
demand for the underlying stock, resulting in price appreciation.

4. Stock shareholders influence company executives to either buy back shares
or declare dividends. This action usually leads to an increase in the underlying
stock price.

5. Alternate uses of cash, such as investing in new projects and acquiring
other companies, may not be as attractive and therefore, companies invest in
their own stocks.

How much have S&P 500 companies bought back since 2009? The answer is
approximately $1.4 trillion. To put this number into perspective, S&P 500
companies' current total market cap is about $15 trillion, and $6 trillion at
the bear market low on March 6, 2009.

It's difficult to determine how much share buybacks contributed to the stock
price appreciation since 2009, but it's safe to say share buybacks made a
significant contribution to our current bull market.

Currently, the monthly relative strength indicator (RSI) reading is 83.7. (A
reading over 70 is considered to be overbought.) To put this figure in
perspective, the monthly RSI of the Nasdaq Composite was 85.9 on March of 2000
(the index peak), and we know what happened afterwards.

Bubbles are formed when investors crowd into investment vehicles; it's
difficult to exactly determine when the bubbles will burst, but they mostly do.
This may be a sign that the rally may be nearing the top.

Overall, I am doubtful that corporations will continue to increase buybacks,
since stocks are no longer. Hence, corporations may not scoop up their shares as
aggressively as they did in recent years the next time the stock market sells
off.

If the economy does not improve, the stock market may become fragile because
slowing stock buybacks may lessen the demand for risky assets. A small equity
sell-off could potentially turn into a double-digit correction. So, it may be
prudent not to chase the current rally.